Tax alert

IRS updates method change procedures for section 174 R&E expenses

Jan 18, 2023
Business tax
Accounting methods Credits & incentives Federal tax R&D tax credit

Executive summary

Rev. Proc. 2023-11 modifies and supersedes Rev. Proc. 2023-8 by denying audit protection to taxpayers that wait until 2023 to implement new capitalization rules under section 174. All other procedural rules governing implementation remain unchanged. 

IRS updates method change procedures for section 174 R&E expenses

The Tax Cuts and Jobs Act (TCJA) amended section 174 of the Code to require capitalization of specified research and experimental (R&E) expenses (new section 174). Under new section 174, specified R&E expenses must be capitalized and amortized over a 5 or 15-year period (depending on where the research takes place), beginning in the year the expenses are paid or incurred. Further, software development costs are treated as specified R&E expenses. This treatment is in stark contrast to the favorable treatment provided prior to amendments by the TCJA, pursuant to which a taxpayer could deduct its R&E expenses and software development costs. New section 174 applies to specified R&E expenses paid or incurred in taxable years beginning after Dec. 31, 2021.

On Dec. 12, 2022, the IRS released Rev. Proc. 2023-8, providing procedural guidance necessary to implement new section 174 (see the prior alert for a detailed discussion of Rev. Proc. 2023-8: IRS issues method change procedures for sec. 174 R&E expenditures). On Dec. 29, 2022, the IRS released Rev. Proc. 2023-11, modifying and superseding Rev. Proc. 2023-8. The general procedures for implementing new section 174 remains largely the same as those provided by Rev. Proc. 2023-8; however, Rev. Proc. 2023-11 eliminates audit protection for taxpayers that wait until their 2023 tax year to implement the new capitalization rules. Specifically, a taxpayer that implements new section 174 in the year subsequent to the first year the new rules apply (i.e., 2023 for a calendar year taxpayer) will not receive audit protection for its prior-year treatment of specified R&E expenditures. Under both revenue procedures, regardless of when a taxpayer implements new section 174, no audit protection is granted for tax years beginning before 2022. Thus, the new revenue procedure primarily takes away the ability of a late adopter of new section 174 to protect any previous, improper deduction of specified R&E expenses.

Rev. Proc. 2023-11 restricts the more favorable terms and conditions generally applicable to voluntary changes in accounting methods and reflects a stricter approach to ensuring that taxpayers implement new section 174 in the first year the rules become effective.   

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